5 Investor Strategies for the Carbon Bubble

Two developments in the last week are turning the heat up on oil companies: HSBC released an analysis finding oil majors at significant risk from "unburnable" reserves, and a pension fund has agreed to consider divestment from fossil-fuel companies in response to NGO pressure. This signals growing concern among conventional investors that climate change could be creating a "carbon bubble" in equity markets.

Climate change scenarios Concerns around carbon dioxide emissions are growing as climate science grows ever firmer on CO2's contribution to climate change. International research bodies – including the International Energy Agency, or IEA – model three possible scenarios for the future in terms of the number of degrees Celsius of average global warming by 2050.

The six-degree scenario, or 6DS, is basically Armageddon. 6DS is the scenario we are expected to see if we continue on our current trajectory. The four-degree scenario, or 4DS, is certainly better, but the World Bank released a report in November 2012 emphasizing that 4DS must also be avoided. The bank projects "unprecedented heat waves, severe drought, and major floods in many regions, with serious impacts on human systems, ecosystems, and associated services." These effects would lead to spreading tropical diseases, crop failure, inundation of island nations, and more.

World governments and institutions have repeatedly committed to staying below the two-degree scenario, or 2DS. To be clear, scientists still warn that a two-degree Celsius increase is the level at which atmospheric feedback loops could trigger dangerous climate change. Therefore, it is this scenario that HSBC used as the basis for its study.

Unburnable reserves To achieve 2DS, the IEA calculates that no more than about 1,440 gigatons of carbon can be emitted globally by 2050. Emissions have already reached 400 gigatons, which leaves only around 1,000 gigatons – or just a third of current proven reserves – to be burned.

HSBC's analysis looked at European oil majors. Norway's Statoil (NYSE: STO) is the worst affected, with approximately 17% of its market capitalization at risk. HSBC also calculated that 6% of BP's (NYSE: BP) reserves are at risk, along with 5% of Total's and 2% of Shell's (NYSE: RDS-A) . However, HSBC finds that a bigger threat to the sector's value comes in the form of reduced demand, which could lead to lower oil and gas prices. In that event, the potential value at risk for leading fossil fuel players could increase to 40%-60% of current market capitalization. The analysts think investors have not priced in this risk, probably because it seems so far off.

But is it so far off? The IEA said in 2011 that on its current trajectory, the world could exhaust its carbon budget by 2017. In 2012, the IEA said that energy efficiency improvements could offer a further five-year reprieve. Even then, the next decade is likely to be when the excrement hits the fan. HSBC projects that a decrease in demand for high-carbon projects could lead to project cancellation, especially for controversial and high-cost projects.

Divestment Meanwhile, the Financial Times is reporting on the 350.org campaign to divest from fossil-fuel companies. The campaign enjoyed a major victory this past week when the Seattle City Employees' Retirement System, or SCERS, agreed to discuss the Seattle mayor's request that it sell its shares of ExxonMobil and Chevron (NYSE: CVX) , among others. 350.org urges universities, governments, and churches to divest from what founder Bill McKibben calls "outlaw companies," whose hydrocarbon assets cannot be burned without serious consequences for climate change.

While SCERS may be a relatively small player, big dogs like the California Public Employees' Retirement System have adopted climate change as a "priority theme," and may soon consider 350.org's argument.

Just to add an additional wrinkle, all of this comes right as The World Future Council releases a report (link opens a PDF) finding that the opportunity cost of using non-renewable fossil fuels for energy, instead of other applications like plastics production, is between $3.2 trillion and $3.4 trillion per year.

Five key investor takeaways Here are five ways that long-term investors can account for these forces in their portfolio management.

Be wary of high-cost, carbon-intensive, and controversial projects. You've got the risk numbers above for some of the European players. Arctic drilling and tar sands exploitation come at a high cost as well. TransCanada's (NYSE: TRP) Keystone pipeline is a perfect example of such a controversial project. Greenpeace has identified it as among the world's 14 most carbon-intensive projects (link opens PDF). On the flip side, the HSBC study found that only 1% of BG Group's market cap was at risk.

Look for investment in carbon capture and storage and renewable energy. You can look for this among pure players and as part of the oil majors' portfolios. Make sure you assess such hard indicators as serious research and development investment, and don't be fooled by clever PR campaigns.

Invest in transport fuel efficiency. The HSBC analysts found that improvements in transport fuel efficiency are an easy way to reduce fossil-fuel demand.

Reassess passive and benchmarked investments.Carbon Tracker makes the excellent point that "asset owners typically invest large amounts in passive funds which track the market, or active funds which are benchmarked against market indices. This means many investors are backing huge fossil fuel reserves purely as a result of the structure of the financial products they invest in. The continued focus on short term returns perpetuates the status quo."

Divest? You could follow 350.org's urgings and divest from the oil majors. While this may sound drastic, consider yet another report that came out last week from The Aperio Group, an investment management firm. "Do the Investment Math: Building a Carbon-Free Portfolio" (link opens PDF) reveals that while divesting from fossil-fuel companies doesn't necessarily add value to a portfolio, nor it does subtract value, and it increases the risk to investors at such a modest level as to be negligible.

How you react to a carbon-constrained world is up to you, but that you should react is beyond question, especially considering that the movement toward alternative energy is gaining momentum. One potential opportunity in this field is Clean Energy Fuels, which focuses its natural gas efforts primarily on trucking and fleets. It's poised to make a big impact on an essential industry. Read all about Clean Energy Fuels in our brand-new report. Just click here to get started.

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